Caterpillar Innovates as Competition Escalates

Over the past century, Caterpillar CAT has skillfully constructed a product portfolio that has made it the largest construction and mining equipment manufacturer in the world. Through this process, it has developed the world’s most valuable heavy equipment brand. While many of the segments Caterpillar operates in are highly competitive, we believe its strategy of investing in optimal product design coupled with strong brand development places it far ahead of the competition and will continue to do so. Moreover, we view Caterpillar as the best-run company in the heavy equipment market and especially like its focus on total cost of ownership.

Caterpillar has created a virtuous cycle by manufacturing superior quality equipment that has fostered a premium product reputation. The equipment therefore is highly fungible with known resale values. It also has a robust support infrastructure, which creates a lucrative aftermarket business.

From compact track loaders to mining trucks with 400-ton capacities, Caterpillar competes in myriad segments of the heavy equipment industry. Complementing this broad range, Caterpillar offers a host of technology solutions through Cat Connect and Minestar, including fleet management systems, equipment management analytics, and autonomous machine capabilities.

While much of Caterpillar’s growth has been organic, it has made significant acquisitions during the past 15 years. The largest of these was the purchase of Bucyrus International, which makes large mining equipment, in 2011 for $8.6 billion. While the timing of the Bucyrus acquisition may have been questionable, it ultimately made Caterpillar a stronger competitor against Komatsu. Caterpillar entered the rail industry after it acquired Progress Rail Services and Electro-Motive Diesel in 2006 and 2010, respectively. We question the synergies of rail with Caterpillar’s core business.

Caterpillar has an installed base of over 2 million pieces of equipment, with over 850,000 of these connected via telematics. Caterpillar benefits from this base as it generates high-margin recurring revenue from the sales of parts. Approximately 54% of its revenue is from outside North America.

Brand Strength and Dealer Network Dig Wide Moat Caterpillar's wide moat rests heavily on its intangible assets, which include the strength of its brand and extensive dealer network that covers the globe. Interbrand has ranked Caterpillar as the world's 89th most valuable brand, worth $4.9 billion. The strength of the brand is boosted by the large amount of Caterpillar-branded clothing and boots available on mainstream online channels such as Amazon.

To a lesser extent, there is highly specific intellectual property that enhances the moat. Caterpillar stresses the lowest total cost of ownership, which we believe to be thoroughly engineered into its equipment from design through manufacture. This is one reason Caterpillar has over 20,000 patents. It was granted 595 patents in 2017 alone, ranking it the 69th on the list of companies with the most patents awarded by the U.S. Patent and Trademark Office that year.

For mining equipment, switching costs are introduced as these machines have long lives with complex service agreements. Moreover, there is a limited talent pool that can service large pieces of equipment that are difficult to transport and for which few competitors exist. This leads to tight relationships between Cat dealers and the owners of the equipment. Many of the industries Caterpillar serves are highly sensitive to downtime, making robust service and parts delivery critical. On a related note, some of its larger and more expensive offerings--large mining equipment, turbines, and locomotives--can’t be easily developed by new entrants. Cat Connect and Minestar are increasingly able to demonstrate financial benefits to its customers. Their capabilities include functions such as remote engine diagnostics, collision avoidance, and even autonomous dozing. Over time, we believe there will be increased switching costs as Cat technology solutions become more pervasive. We believe these advances should weaken competitive threats that are likely to increase in certain areas.

One of the big strengths of Caterpillar is the breadth of its dealer network. With 168 dealers, employing 157,000 employees at 2,163 branches, Caterpillar has significant coverage on every continent. Except for turbines and locomotives, Caterpillar sells its products through its dealers. These independently operated companies are often large organizations that exclusively sell Caterpillar products. It would be very difficult for new entrants or existing competitors to duplicate the scale and coverage of Caterpillar dealers. Two dealers in Canada, Finning and Toromont, are large enough to be publicly traded companies.

The cost to replicate Caterpillar’s worldwide dealer branches would be enormous--arguably more than $20 billion. More important, the replication efforts might be futile because no other heavy equipment company has the completeness of Cat’s product line to fully support a branch. Hence, many competitors’ products are sold at dealerships that carry multiple product lines that often compete with one another.

Caterpillar focuses on providing the lowest total cost of ownership, so the robust service it can offer its customers is a source of competitive strength. The total cost of ownership encompasses equipment reliability, rapid access to a large parts distribution network, good fuel economy, and even the most efficient ergonomics for operator performance. By our calculations, the total cost of ownership is 3-4 times the initial cost of a moderate-size piece of equipment when including fuel, routine maintenance, operator labor, and repairs. This ratio can get much higher with larger, more expensive pieces of equipment with extremely long lifespans. For example, the first of Caterpillar’s largest mining trucks--the 797--entered service in the Canadian oil sands in 1999 and is still operating after 130,000 hours of use. In this case, the purchase price would be less than one tenth of the total cost of ownership.

Concerns about competitive threats from Chinese companies LiuGong, Sany, XCMG, and Zoomlion are real. Our channel checks suggest Sany equipment (specifically excavators at the moment) sold in the United States costs approximately 25% less than U.S. brands (for example, Caterpillar, Deere DE, Case CNHI). However, repairs of these machines can be problematic as parts are harder to obtain and fewer U.S. technicians are familiar with the equipment.

In response to competitive threats, Cat has differentiated its products to serve the value-oriented customer who is more focused on initial price than on total cost of ownership. In 2008, Cat acquired Shandong SEM Machinery, which now manufactures a range of SEM-branded products in China for use in emerging markets. Currently, Caterpillar manufactures a few models of Cat-branded equipment in China for export to the U.S. The strategy ultimately provides a fully stratified product line with different levels of utility.

Caterpillar exhibits the characteristics of a cyclical business, which is expected from a company that focuses on natural resources and construction. However, neither the segments nor geographic regions are completely synchronized. This provides a revenue buffer that can bolster returns on invested capital when particular segments or geographic regions are weak. Our analyses of global markets suggest many of the geographic/segment combinations are below midcycle levels. Specifically, parts of U.S., Latin America, and the Philippines look attractive. It also helps that the significant installed base generates revenue from the sale of replacement parts. Meanwhile, the financial division slightly buffers overall revenue.

Main Risks Are End-Market Volatility and Competition Caterpillar has two primary risks. First, is the risk related to its end markets: construction, natural resources, energy, and transportation. All of these can be quite volatile with resource industries exhibiting the most extreme volatility. China's rapid urbanization is likely to moderate at some point, reducing the global demand for iron, copper, and metallurgical coal. At the same, such a downturn could reduce the need for construction equipment. We currently believe Chinese construction will remain flat over the next decade.

Second, Caterpillar faces competition from companies large and small, domestic and abroad. Many of these competitors have existed for decades while some, primarily the Chinese brands, are new. Sany’s growth has been particularly impressive, with a revenue compound annual growth rate of 9.2% over 2009-17. Whether these newer companies can compete on quality and total cost of ownership remains to be seen. Further, developing a global dealer presence like Caterpillar currently appears infeasible.

Rapid technological change is also possible. While Caterpillar has been a leader in this regard, existing competitors like Komatsu KMTUY and startups like Built Robotics are making strides in autonomous technologies in the mining and construction sectors. It’s possible that a startup with technology useful to Caterpillar will be acquired by a competitor.

Geopolitical risks can also be a factor for export competitiveness and ease of manufacturing abroad. While considered relatively minor currently, tariffs could become more onerous in the future. If an aggressive trade war erupts, Caterpillar could have restrictions placed on its operations in foreign countries.

Tertiary risks include environmental, social, and governance matters. Coal represents approximately 30% of the commodities mined by Caterpillar equipment. Also, there have been isolated incidents in which Caterpillar bulldozers have been used in contested Palestinian territories by Israeli authorities.

Caterpillar maintains a strong cash and liquidity position, and we expect its financial position to strengthen over the next five years as it produces significant cash flows. We anticipate the company’s total debt/EBITDA ratio for its primary business, machinery and transportation, to trend downward from 0.80 in 2018 to 0.65 in 2023, due in part to improved operating performance.